Model Audit

A model audit is the colloquial term for the tasks performed when conducting due diligence on a financial model, in order to eliminate spreadsheet error. (Also known as Model Review in some areas). A study in 1998 concluded that even MBA students with over 250 hours of spreadsheet development experience had a 24% chance of introducing spreadsheet error. Model audits are typically requested by banking organisations, in order to reassure lenders and investors alike that the calculations and assumptions within the model are correct, and that the results produced by the model can be relied upon. When a comprehensive review of the model is required, the scope of review is often extended to include tax and accounting, sensitivity testing and the checking of data contained within the model back to the original financing and legal documentation.

Purpose

The purpose of a model audit is to provide assurance that the results can be relied upon. For this reason, the party conducting the review will provide a level of reliance on the form of an amount of liability. This may range from a multiple of the fee (2×, 3×, 4× fee, etc.) to a fixed amount, often up to US$20 million. In the event an error or omission is found in the model due to the model auditor's negligence, the organisation relying on the report may choose to sue the model auditor in order to recover any loss.

The objective of the model audit should be to the reduce financial risk that is being taken on by under  the transaction to which the financial model relates. As such, it is more important to ensure that the model audit has the proper scope, and is undertaken using a robust methodology, to identify material errors than to negotiate a liability cap if material errors are not identified. The model audit is not, or at least not as a primary purpose, an insurance policy, it is for reducing the financial risk that is being taken on.

Typical scope

For a full-scope model audit, the following elements would usually be included:

§  A review of the model's logic;

§ A review of the model's consistency with financial and contractual documentation;

§  A review of the model's consistency with local GAAP and tax;

§  A sensitivity review.

Application

Model audit has predominately been related to Public Private Partnership ("PPP") transactions (including PFI in the UK and P3 in the USA), but is increasingly applicable to wider project finance and infrastructure finance transactions.

Model audits are applicable to any financial model that is used to support to the taking on of any financial risk, e.g. valuation models, operational models, refinancing models, portfolio model, M&A models etc…

How is it conducted?

Most financial models are produced using Microsoft Excel. The model will routinely contain a number of pages of input data, a sheet of formulas (the 'workings') which drive the model, and the output pages, which are usually in the form of standard financial statements (balance sheet, income statement, cash flow statement, etc.).

Model auditors may undertake a detailed 'bottom-up' review (cell-by-cell checks) of each unique formula, and/or combine a 'top-down' analysis such as the reperformance of calculations based upon the project's documentation ("shadow modelling"), analytical review of trends in key outputs, sensitivity analysis and commercial sense checking.

Debate on alternative approaches

As noted in the citations, Andy Hucknall of PKF (UK) LLP (and many others) argues that the combination of a 'bottom up' all-cells review with 'top-down' analytical review gives the greatest assurance, whereas the alternative 'top down'-only approaches, such as shadow modelling, may provide a limited level of assurance that may be appropriate in some circumstances. An approach including an 'all cells' review will always provide more assurance as issues related to options not currently active in the Model, such as scenarios or alternative inputs, will not be identified where a reperformance only approach is used as such issues will only be identified by carefully reviewed a model's logic. That said, an 'all cells' review without 'top down' analytical review would lose context, so it is important to use both techniques.

An alternative argument, put forward by Jerome Brice of Mazars LLP, is that shadow modelling provides sufficient assurance.

Providers of model audit services

Given that the concept of formal model audits is thought to have started with early UK PFIs, many of the long-standing model audit firms are based in London. Many of the newer entrants to the market are based in Australia.

Some of best known model audit firms are:

§  PKF (UK) LLP(London)

§  Operis plc (London)

§  Ernst & Young (London)

§  Mazars LLP (London)

§  Corality (Sydney)

§  KPMG (Melbourne)

Many of the above firms, such as PKF, E&Y, Mazars and KPMG, are major accounting firms. This enables them to provide the tax and accounting reviews (usually required in a model audit) in-house or through their internationals networks, avoiding the need for separate subcontractors.

Software for model audit

Spreadsheet tools and software are useful to the model auditor for assessing the model and for identifying potential errors, but are not an alternative to properly planned, scoped and undertaken model audit. Commonly used tools include OAK, SpreadsheetProfessional, SpreadsheetAdvantage, Arixcel Explorer and others.

Cost and duration

A model audit may take between 1 and 5 weeks, but this does not include the time taken by the model author to rectify the errors identified by the model auditor. The fee is largely dependent upon the scope of review, and if done properly, the number of unique formulae and their complexity.

The cost will also depend on the seniority of staff undertaking the work. Planning of the model audit, as in a statutory audit, is vital to mitigating risk, and thus this needs to be undertaken by senior staff. In planning, the elements of the model audit should be allocated to staff with the appropriate level of experience, technical expertise (e.g. tax or accounting) and seniority. The senior staff needs to look at the big picture of the model to ensure that it makes sense as a whole.